Cap rate vs DSCR
By Jude Wallis
Both start from net operating income and then ask different people's questions. Cap rate divides $36,000 of NOI by a $480,000 price, which is 7.5 percent, and tells a buyer what the building yields. DSCR divides the same $36,000 by $24,000 of debt service, giving 1.5, and tells a lender whether the loan is covered.
| Cap rate | DSCR | |
|---|---|---|
| Denominator | Purchase price or value, $480,000 here. | Annual debt service, $24,000 here. |
| Answer on this deal | 7.5 percent. | 1.5 times. |
| Whose question | The buyer's: what does this cost per dollar of income. | The lender's: can the income miss and still pay me. |
| Effect of borrowing more | None. The ratio does not know about the loan. | Falls immediately, because debt service rises. |
| What a change signals | A different price, a different market, or a different risk view. | A thinner cushion between rent and the mortgage. |
| Typical threshold | Compared against other buildings in the same market. | Lenders often want at least 1.2 before advancing. |
On this page
One denominator is the price, the other is the loan
Cap rate is an income yield. Take $36,000 of NOI, divide by the $480,000 price, and the answer is , a 7.5 percent cap rate. That number is comparable to any other building in the same market because financing never entered it.
DSCR is a cushion. Take the same $36,000 and divide by $24,000 of annual debt service, and coverage is 1.5. Income could fall by a third and the mortgage would still be paid. Change the loan, and the cap rate stays exactly where it was while the coverage moves.
They fail in different directions
A high cap rate is not automatically good news. It can mean a cheap price, and it can mean a market that expects the rent to fall or the building to need work. A high DSCR is more one-directional: more coverage is more safety, though it also usually means less borrowing and so less of the return going to the equity.
What neither one measures is the price against the rent roll directly. That is what the one percent rule does as a rough screen, and on this property $4,000 of monthly rent on a $480,000 price is 0.83 percent, which fails it. Three ratios, three answers, one building.
Using them in order
Screen with the cap rate, because it compares buildings. Size the loan with DSCR, because it compares income to the payment. Then check the assumptions underneath both, since they share a numerator: an NOI that quietly excludes a real expense flatters the yield and the coverage at the same time. The cap rate calculator, the DSCR calculator and the one percent rule calculator run the three screens, and how cap rates work covers what a market cap rate is telling you. This is educational material, not financial advice.
Worked examples
Coverage on \$36,000 of NOI
A rental produces $36,000 of net operating income and carries $24,000 of annual debt service. What is the coverage ratio?
- Divide NOI by debt service: 36,000 over 24,000.
- That is 1.5, so income is one and a half times the annual mortgage cost.
DSCR is 1.5. Income could fall by a third before the $24,000 of debt service went uncovered.
The rent against a \$480,000 price
The same property rents for $4,000 a month and is priced at $480,000. What does the rent to price screen say?
- Divide monthly rent by price: 4,000 over 480,000.
- As a percentage that is 0.83 percent, short of the one percent screen.
Monthly rent is 0.83 percent of the $480,000 price, and the $36,000 of NOI on that price is a 7.5 percent cap rate.
Common questions
Can a property have a good cap rate and a bad DSCR?
Easily. Borrow enough against a 7.5 percent yield and coverage falls below what a lender will accept.
Does the cap rate include the mortgage?
No. That is the definition. A yield that includes financing is a cash on cash return instead.
What DSCR do lenders want?
Commonly 1.2 or better on residential rentals, higher for riskier property types. The threshold is theirs, not the market's.
Is this financial advice?
No. It is educational material about two ratios built from the same net operating income.
Keep reading
This page is educational material, not financial advice. The figures come from the formula shown and assume the inputs you enter hold for the whole term. Your own rate, fees, taxes and timing will differ, so treat the output as arithmetic to check a decision against, not as a recommendation.